Policymakers Learn a New and Alarming Catchphrase

Gillian Tett, Financial Times

Monday, 9 May 2011 | 11:58 PM ETFinancial Times

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Another week, another wave of dismal fiscal gridlock in Washington. But as US politicians squabble about how to cut the debt, another concept with a catchy name is quietly starting to creep into the policy debate: "financial repression".

U.S. Savings Bonds

A few weeks ago, Carmen Reinhart, a US economist who shot to fame two years ago by co-authoring an influential book on sovereign debt, This Time Is Different, produced a joint paper for the International Monetary Fund on the topic of "financial repression" in the west. And while this phrase is not yet mainstream news, it is starting to generate a buzz among the policy elite in Washington and in some European capitals.

The issue at stake revolves around the question of where investors "choose" to put their money. During the past three decades, western savers have generally assumed they could put their money wherever they wanted, since financial markets were organized according to the mantra of globalization and free market capitalism - and thus the price of money (or interest rates) was set largely by demand. But as Ms Reinhart and Belen Sbrancia, her colleague, point out, this freedom was unusual. In the 1920s, global capital markets were also pretty free. But, from the 1940s to the 1980s, western governments operated capital controls and interest rate caps that restricted financial flows, limiting investor choice.

It is often assumed that these controls were driven by a wave of financial reforms after the 1929 stock market crash (just as governments are implementing financial reforms now). And that is partly true. However, Ms Reinhart and Ms Sbrancia argue that these controls also had a crucial fiscal impact. After the second world war, the debt of the advanced economies spiraled to about 90 percent of gross domestic product, roughly comparable to today, which meant western governments desperately needed to find investors to buy the bonds.

One consequence of the controls was they created a captive domestic audience for those bonds. Better still, because these bonds paid a yield lower than inflation, whenever those captive investors bought bonds, they effectively paid a hidden subsidy to the government, enabling them to reduce the debt.

Ms Reinhart and Ms Sbrancia argue the world has forgotten that the widespread system of financial repression "played an instrumental role in reducing or 'liquidating' the massive stocks of debt accumulated during World War II". Between 1945 and the 1980s, they say the US and UK's "annual liquidation of debt via negative real interest rates" on average amounted to 3-4 percent of GDP per year, or 30-40 percent of GDP debt reduction over a decade.

These days nobody is talking about introducing overt capital controls or interest rate caps in the west. And central banks appear determined to curb inflation. But some influential investors fear eventually the temptation to let inflation jump above bond yields will reappear. "While the ancient Romans used to shave metal coins in an attempt to monetize debts, our evolving financial system has used more sophisticated techniques [to cut its debt]," says Bill Gross, head of Pimco investment fund. "Bond prices don't necessarily have to go down for investors to get skunked."

Central banks such as the Federal Reserve have already been buying bonds. And there are now some intriguing hints that private sector institutions are being urged to hold more bonds. In the UK, the introduction of financial reforms has forced banks to purchase more gilts. Similar steps are afoot in other parts of Europe and in Washington some policymakers are quietly mulling whether US banks and pension funds could - or should - follow suit, especially if foreign buyers (who own half the US debt) stop buying US bonds.

Such moves horrify some free-market economists, who argue "repression" crimps private sector investments, thus undermining growth. But postwar politicians clearly decided this was a price worth paying to cut debt and avoid outright default or draconian spending cuts. And the longer the gridlock over fiscal reform rumbles on, the greater the chance that "repression" comes to be seen as the least of all evils; at least compared with others that may emerge from spiralling western debt.

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